Thursday, November 25, 2010

Robert Barro claims that quantitative easing should expand aggregate demand, but that it is equivalent to the Treasury refinancing the national debt by selling T-bills and purchasing longer term government bonds. Why should the Fed be involved in what should be a Treasury operation?

Barro asserts that the Fed fears that when it comes time to sell off the government bonds it has purchased, that these sales will choke off economic recovery. That is why, according to Barro, the Fed is proposing to instead raise the interest rate paid on the reserve balances. But Barro argues that raising the interest rate paid on reserves will have the same contractionary effect as selling off bonds and reducing the quantity of reserves.

I think Barro is correct regarding the consequences of quantitative easing, but I think his approach is wrongheaded. Quantitative easing will raise money expenditures. It is certainly possible that having the Treasury refinance the national debt by selling T-bills and purchasing long term bonds could substitute for the Fed purchasing long term bonds. And raising the interest rate that the Fed pays on reserve balances would have much the same effect on money expenditures and output as the Fed selling off bonds.

From the quasi-monetarist perspective, the problem with the "zero bound" on T-bills (or any security) is that rather than a shortage of T-bills causing a higher price and lower yield on the T-bills, there is a spillover to an added demand to hold money. Assuming that the demand for money was intially equal to the existing quantity of money, the result is a shortage of money and reduced money expenditures on goods and services--a general glut of goods.

If the central bank responds to the shortage of money by expanding the quantity of money as it should, but it does so by purchasing T-bills (or whatever security is at the zero nominal bound,) then while the increase in the quantity of money directly corrects the shortage of money, the increase in the demand for T-bills exacerbates the shortage of T-bills, and with no increase in the price or decrease in the yield of T-bills possible, there is an additional spillover to added money demand, completely offsetting the increase in the quantity of money. The implication is clear--the central bank should not seek to expand the quantity of money by purchasing securities that have yields so low that holding money is a better alternative.

Economists like Barro do not like this sort of messy disequilibrium analysis. Instead, their bias towards equilibrium reasoning results in boiling this down to "T-bills and money are perfect substitutes when the yield on T-bills is zero." From that perspective, if the yield on T-bills is zero, then the quantity of currency and reserve balances plus the quantity of T-bills held by the public forms a single homogenous good. If we call this good, "base money," then when the interest rate on T-bills hits zero, suddenly, the quantity of base money rises by the existing quantity of T-bills. Of course, the change in definition implies that the demand for this base money rises by an equal amount. If the Fed purchases more T-bills with money created out of thin air, the total quantity of "base money" is unchanged.

If the Fed instead purchases long term government bonds in the usual way, expanding banks' reserve balances at the Fed, then the total of base money--currency, reserve balances and zero-interest T-bills, expands, which perhaps results in additional money expenditures on goods and services. From Barro's perspective, if the Treasury were to refinance the national debt by selling more T-bills and paying off long term government bonds, then the effect is the same. "Base money," made up of currency held by the public, reserve balances of banks, and zero-interest T-bills would expand the exact same amount.

But when Barro then asks why the Fed should be doing something that is equivalent a Treasury refinancing, he falls into confusion. It isn't that the Fed is involving itself in the Treasury's determination of how it should fund the national debt. It is rather that with T-bills bearing a zero yield, they are, in Borro's approach, equivalent to base money. If the Treasury sells more T-bills, according to Barro, it is expanding the quantity of base money. It is the Treasury that would inevitably be involved in monetary policy if it issues T-bills with a zero nominal yield.

However, his conclusion is sound. Suppose there is a shortage of T-bills at a zero yield. Rather than allowing this shortage to spill over to a shortage of money, suppose the Treasury refinances its debt, issues and sells more T-bills, and uses the funds to pay off longer term government bonds. The Treasury should be able to prevent any excess demand for T-bills and so avoid the spill-over to an excess demand for money. Of course, if the Fed refinances the entire national debt with T-bills, and there is still a shortage of T-bills, then nothing further can be done by the Treasury. Oddly enough, in that situation, there would be no long term government bonds for the Fed to purchase. The Fed would have to look to purchase other types of assets--perhaps private bonds.

If the Fed and the Treasury are consolidated, then monetary policy is a matter of how to fund the national debt. How much should be funded by the issue of hand-to-hand currency? How much by reserve balances to be held by banks? How much by T-bills? And finally, how much by T-notes and T-bonds of various maturities?

If the monetary authority is independent with some kind of nominal restraint, then it is up to the Treasury to fund the national debt and it is up to the monetary authority to control the issue of currency and bank reserves to hit its nominal target. The monetary authority doesn't have to limit its asset portfolio to government bonds. And to the degree it does purchase government bonds, the rule that it should not be buying any that have zero nominal yields makes more sense than treating all T-bills as base money when their yield falls to zero.

What about Borro's point that raising the interest rate the Fed pays on reserves is just as likely to choke off recovery as the Fed rapidly selling off its asset portfolio? From a quasi-monetarist perspected, this is exactly correct. The increase in the interest rate paid on reserves increases the demand for reserves and base money. By rapidly selling off its government bond portfolio, the Fed is decreasing the quantity of reserves and base money. What is important is excess demands for base money, not whether the excess demand occurs through a higher demand or a lower supply.

More importantly, the reason to raise the interest rate on reserve balances or sell off bonds to reduce the quantity of reserves is to prevent an excess supply of reserves from developing as the demand for reserves fall and commercial banks buy bonds or make additional loans as the economy recovers. The increase in interest on reserves offsets the decrease in demand, and the sale of Fed assets reduced the quantity of base money to match the decrease in demand. The whole point is not to cause a contraction but to prevent an excessive expansion.

The reason to raise interest rates on reserves rather than selling off assets is for the Fed to avoid capital losses on the asset portfolio. If the Fed raises interest rates on reserves enough, it will have higher costs, and perhaps its costs will rise above its earnings on its asset portfolio. But, it can suffer losses for a long time before it runs out of assets. Further, if there remains a large demand for zero-interest hand-to-hand currency for some time, that is a source of profits that could offset losses from paying interest on reserves. If the Fed had to rapidly sell off long term bonds (much less mortgage backed securities,) insolvency could arrive rapidly. Sure, there is no real distinction in present value terms, but in political terms, an open and transparent bailout of the Fed would be very different than reduced payments to the Treasury over the next 20 years.

Tuesday, November 23, 2010

Quantitative easing involves an increase in the quantity of money. There are different ways to define and measure the quantity of money, and so that leaves quantitative easing a bit vague. Since the Federal Reserve has promised to purchase $600 billion of government bonds over the next few months, the quantity being directly increased is the monetary base--currency held by the public and reserve balances banks keep at the Fed.

When the Fed creates base money, it directly increases the reserve balances that banks keep at the Fed--reserves. The Fed purchases the bonds, and pays for them by increasing the reserve balance of some bank. Further, the Fed purchases bonds directly from a limited set of primary dealers, all of which are large financial institutions, and many of which have commercial bank divisions that keep reserve balances at the Fed.

Given these institutional realities, one might see this quantitative easing as a policy that aims to buy $600 billion worth of government bonds from banks, so that the banks will now have less government bonds and more reserves. The question, then, is what will the banks do with these additional reserves. Will they make new loans to households and small business?

This perspective is mistaken. While it is true that the Fed directly increases bank reserves when it adds to the monetary base, the monetary base is made up of both currency and bank reserves. Withdrawals of currency by households and firms other than banks from their deposit accounts at banks would reduce the reserves of the banks, increase currency holdings, and leave the total monetary base unchanged.

More importantly, the primary dealers from whom the Fed directly purchases government bonds are middlemen. They are purchasing government bonds from other banks, firms other than banks, and households, in order to sell to the Fed. Any impact of quantitative easing on the transactions accounts (checking accounts) of those primary dealers that are not commercial banks or the reserve balances of those primary dealers that are banks are transitory. To the degree that those from whom the primary dealers buy are banks, then they have shifted from holding government bonds to reserve balances. To the degree that those from whom the primary dealers buy are not banks--are commercial and industrial firms or households--the quantitative easing raises the balances in their transactions accounts. In other words, households and firms selling the bonds have more money in their checking accounts.

So, quantiative easing also directly increases the quantity of money held by members of the nonbanking public--households and firms other than banks. To the degree that banks use their additional reserves to make loans, including purchasing other bonds (presumably other than the ones they sold directly to the primary dealers and indirectly to the Fed,) then those selling to those who received the loans, or those who sold the bonds, will also have larger transactions balances.

This is the conventional "money multiplier" process, that allows a given increase in base money created by the Fed to be multiplied. While it is possible to look at this by considering how much new money will be available for households and firms to hold given the amount of bonds purchased by the Fed, a better way to think about it is to see it as impacting the amount of bonds the Fed must purchase to get the desired increase in the quantity of money in the hands of firms and households.

Why would the Fed want to increase the quantity of money in the hands of the public? In order for households and firms to spend more of that money on consumer goods and capital goods in the near future. So, one important issue is whether or not households and firms who receive new money by selling bonds to the Fed or banks, or perhaps obtain loans from banks, will spend some or all of that money on consumer goods or capital goods.

If the banks don't increase loans, and households and firms will spend none of the money they receive from selling bonds on consumer goods or capital goods, and instead just leave that money in their transactions accounts, then quantitative easing will not have the desired effect. If, on the other hand, banks lend even a bit more of their additional reserves to households or firms who presumably will spend the borrowed funds on consumer or capital goods, and/or the households and firms spend even a bit of the money received from selling bonds on consumer goods or capital goods, then quantitaitve easing has had its desired effect at least to some degree.

It is possible to take a given amount of bond purchases by the Fed, and then try to determine how much will be held by banks as added reserve balances or else lent or used to purchase bonds, and so, how much the quantity of money will rise, and then, consider how much of that new money, when received by households and firms, will be spent on consumer goods and capital goods. However, a better perspective is to turn that around. What is the appropriate increase in spending on consumer goods and capital goods? How much does the quantity of money need to increase so whatever the part that is spent would be the needed amount? How many bonds must the Fed buy in order to increase the quantity of money that needed amount?

One way to look at this is to estimate what will be the income velocity of money. The needed change in spending on goods and services divided by the estimate for the income velocity of money is the needed change in the quantity of money. Then, it is necessary to estimate the money multiplier. The needed change in the quantity of money divided by the estimate of the money multiplier determines the needed change in base money. And that is how many bonds the Fed needs to buy.

Now, what is the reason to get households and firms to spend more on consumer goods and capital goods? This increase in spending will result in firms selling more. If firms can sell more, and they have the needed capacity, they will produce more. Real output, real income, and employment will all increase.

Of course, if the firms are already selling at a rate that matches their productive capacity, then the increase in spending will still occur. Firms would still like to produce more. But because they don't have the needed machinery, workers, and raw materials, they will not be able to produce more. Still, they will be able to make more money by raising prices. And they will be willing to offer to pay more for the limited amounts of resources, machinery, raw materials, and labor. And so, resources prices, including wages for the right kinds of labor, will also rise. In other words, the quantitative easing will lead to inflation.

So, this second problem with quantitative easing is not that it will have no effect. It is rather that the desired effect--increased spending--will have little or no desirable consequences. There will be at most a minimal increase in production and employment and instead simply be more inflation.

Of course, we know that spending in the economy fell approximately 13 percent below its trend growth path of the Great Moderation. The most signicant problem that firms face is not bottlenecks in productive capacity, but weak sales. Increased spending, will solve that problem. Will production and employent rise the level of the Great Moderation? No, productive capacity has been depressed. But the least bad response to depressed productive capacity is a higher price level, which does imply a temporary increase in inflation.

The Fed's proposal to purchase government bonds is a change in the right direction. Spending is too low, which implies the quantity of money is too low, which implies that base money is too low. Of course, the Fed should reduce the interest paid on reserves to slightly less than zero. And, most importantly, the Fed should commit to a target for slow steady growth of money expenditures.

The assumption, of course, is that the problem is recession and that it is being caused by real expenditure being less than the productive capacity of the economy. On the other hand, one could ask why free market economists don't address inflation by calling for cuts in government spending rather than monetary restraint.

I think the best answer is "truth." Economic understanding leads to support for free markets and also an understanding that any problem with an imbalance between productive capacity and real expenditure is due to an imbalance between the quantity of money and the demand to hold money. While changes in taxes, government spending, and budget deficits might impact the demand to hold money in a way that can correct imbalances, changing the quantity of money goes directly to the heart of the problem.

As Caplan points out, hard core Austrians and libertarians often dismiss both monetary and fiscal policy. While some of them lack a sound economic understanding, many do understand the situation. If the quantity of money is not changed, then the market process that corrects an imbalance between the demand to hold money and the quantity of money is a change in the price level. Money prices, including the prices of resources, such as the wages paid to labor, must decrease enough to raise the real quantity of money to match the demand to hold money. At the same time, this reduction in the price level will raise real expenditures on goods and services enough to match the productive capacity of the economy.

The debate, then, between those free market economists who favor an expansion in the quantity of money and those who oppose such changes depends on whether the problems associated with moving to a lower price level are worse than the problems created by monetary institutions that generate an increase in the nominal quantity of money when needed. While there may be exceptions, most agree that the market system would work imperfectly, but government intervention, which would include some regime that allows for changes in the quantity of money, has its own dangers. Just as the more moderate free market economists accept government provision of national defense, despite the possibilities for abuse, many also accept an increase in the quantity of money engineered by a government central bank, despite the dangers. (Strawman? Read some hard core Austrians and libertarians.)

The anti-market economists, on the other hand, focus on special cases where the market process fails to work. The arguments against "monetary policy" may not always apply equally well to increases in the real quantity of money generated by a lower price level, and vice versa, but every rhetorical trick in the book is used. If prices and wages fall in proportion, real wages don't fall and employment doesn't rise. Like the need isn't for the real quantity of money to rise to match the supply. There is no shortage of money. No one wants to borrow. You can't push on a string. Like the problem is with loans rather than an imbalance between the quantity of money and the demand to hold it.

And what is the solution from the anti-market perspective? An increase in government spending--a more extensive provision of government services. Nearly as good is an expansion of transfers to the poor. And while tax cuts are supposedly of doubtful use, if the tax system is made more progressive, to further reduce the relative burden of government on those with lower incomes, that just might do the trick.

Sure, all of this will work only to the degree that those who fund these expenditures, transfers, or tax cuts by purchasing government bonds at least partially pay for the bonds by reducing their desired money balances. Or, of course, in reality, the bonds are purchased by the central bank, so that the quantity of money is rising to meet the demand to hold money after all. The true nature of the problem is all hidden in order to implement a political program that big government economists favor at all times--an expanded welfare state.

Still, this doesn't explain why free market economists don't advocate tax cuts to expand real expenditures when they are too low relative to productive capacity and cuts in government spending to shrink real expenditures when they are greater than productive capacity. Isn't the problem with the tax cuts obvious? Given government spending, tax cuts result in an increase in the budget deficit and a higher national debt.

While supply side economists, new classical ricardianequivalentists, and hard core Austrians and libertarians may consider budget deficits and government debt to be nonissues or a lesser evil, many free market economists, particularly those with a "Virginia School" background, are very skeptical of government borrowing. Are we supposed to advocate higher taxes later? Or is it lower taxes in the recession and then lower government spending to balance the budget and pay off the accumulated debt after the recovery?

Perhaps. But this looks too much like some kind of political strategem aimed at shrinking the size of government. Tax cuts to create jobs! Look at the the national debt. We are going bankrupt. Cut government spending! (Unfortunately, the Karl Roves of the world don't always get on board with the second half of the plan.)

In my view, making clear the cost of taxes so that voters can compare them to the benefits of government spending is important. If budget deficits and national debt are used smooth fluctuations of tax revenues and government spending, it is that much more important that any changes in the demand to hold money associated with those fiscal changes are offset by changes in the quantity of money to maintain money and real expenditures. That reducing government spending to balance the budget or reduce the national debt would be associated with lower money expenditures and recession is one of the worst possible institutional frameworks for a sound fiscal policy. (Don't cut government spending, you are destroying jobs. A correct response would be that we just need to lower wages and prices, and real expenditure would be maintained. But that is not a political battle worth fighting)

Most importantly, the "problem" with recession just isn't that taxes are too high and government debt too low, causing too little real expenditure. The problem is that the real quantity of money is too low relative to the demand to hold money. The alternative solutions are a lower price level or a higher quantity of money. Fiscal policy is just a distraction--and it is clear that both left and right have reasons why they might want to create just such a distraction.

Saturday, November 20, 2010

Public Choice economist William Shughart criticizes quantitative easing. His argument? It is the old Keynesian argument that you can't push on a string. He writes:

The key assumption behind "QE2" is that credit markets are frozen - and lenders are reluctant to lend - because the financial system lacks sufficient liquidity. But banks are awash in loanable funds.

No, the key assumption behind QE2 is that real expenditures are less than the productive capacity of the economy, and that an increase in the quantity of money--the amount of money available for firms and households to hold--will result in an increase in money expenditures on goods and services. Whether credit markets are frozen or whether the financial system has sufficient liquidity is irrelevant.

When the Fed purchases government bonds it directly increases the money balances of those households and firms that sell the bonds. Unless the demand for money increases dollar-for-dollar with the increase in the quantity of money, the resulting excess supply of money will generate increased expenditures. While those selling the bonds may purchase other financial assets, what do those who sell those assets do with the money? At least some of the excess money is almost certainly spent on goods and services, which is the goal of quantitative easing.

When the Fed purchases bonds, it also increases the reserves of the banks. If the banks use those reserves to lend, then the quantity of money will increase by more than the value of the bonds purchased by the Fed. The operation of the money multiplier reduces the amount of bonds the Fed needs to purchase to generate the needed change in the quantity of money. While banks might make consumer or business loans, they can also "lend" by purchasing existing bonds. While having banks use increased reserves to expand lending is a possible consequence of quantitative easing, motivating banks to make more loans is not the purpose of quantitative easing and it is not necessary for quantitative easing to achieve its purpose--to expand spending on final goods and services.

Even if the Fed succeeds in reducing long-term interest rates, the economy will not necessarily be out of the woods. Artificially low interest rates induce businesses to undertake projects that otherwise would be unprofitable. Not to worry too much, though. Investors have been selling Treasury securities in anticipation of the Fed's buyback plan, raising yields to levels not seen for three months.

Admittedly, listening to Keynesian advocates of quantitative easing--it is supposed to lower real interest rates and stimulate real expenditure by a combination of lowering nominal interest rates and raising expected inflation-- can be misleading. However, it is sad when free market economists respond with the old-fashioned Keynesian critique of monetary policy--the banks already have plenty of reserves, they have plenty to lend, and no one wants to borrow. You can't push on a string--the traditional refrain of those who confuse money and credit.

Restricting government spending, tax reform and deregulation, would all help end the slow down in productive capacity shown by the CBO estimate of productive capacity. Perhaps such policies would result in a reduction in the demand for bank reserves or the demand for money, resulting in more spending on goods and services. However desirable such policies might be, they are not arguments against a monetary policy that does its job--adjust the quantity of money to meet the demand to hold money and keep money expenditures on output growing at a slow steady rate.

Suppose there is a $15 trillion economy made up of five equally sized industries, a through e. The demand for money rises, and those choosing to hold more money reduce their expenditures on the products of industry a. The output of industry a remains unchanged, and the price of the product of industry A falls in proportion to the reduction in money expenditures. Money expenditures on the products of industries b through e are unchanged, as are their prices and output. The price level has fallen, increasing the real quantity of money. The real quantity of money rises to meet the demand to hold money. There appears to be no decrease in real output. There appears to be no disruption at all to industries b through e. Only industry a, where demand fell due to the increase in money demand, suffers a loss of money expenditures. The price of that product did need to fall enough so that the lower money expenditures will purchase the unchanged quantity of real output. Real output is maintained.

Sounds plausible enough. However, add some numbers. The quantity of money is $1.5 trillion. The demand for money rises 20 percent, or $300 billion. So, expenditures on the product of industry a fall by $300 billion, which is 10 percent decrease in expenditures. The price of the product of industry a falls 10%, leaving the real volume the output of industry a unchanged.

The price level is now 2 percent lower. (That is, a 10 percent price decrease in an industry that makes up 20 percent of the economy.) This increases real balances by slightly more than 2 percent. Since the demand for money rose by 20 percent, there remains a shortage of money. Now, those who reduced their expenditures on the product of industry a, particularly those who provide resources to industries b through e have accumulated more money. As is the usual account of monetary disequilibrium, those in industry a, who are receiving 10 percent less money expenditures reduce their purchases of the products of industries b through e. While the decrease in the demand may initially have been solely for industry a, the rot spreads.

Reduced money expenditures for the products of industries b through e, and perhaps further reductions in money expenditures on the product of industry a, result in lower prices until the price level falls the approximately 17 percent needed for real balances to rise 20 percent. If there has truly been a shift in relative demands, so that industry a shrinks and one or more of the others grow, then such a change will occur as the real capital gain generated by the increase in real balances is expended on the products of various industries.

However, it would be possible for the initial reduction in money expenditures for the product of industry a to result in a decrease in the price of the products of industry a sufficient for the price level to fall the necessary amount. Suppose the income velocity of money is 1.25, and people hold money balances equal to 80% of income. In the example above, if the quantity of money was $12 trillion, the 20 percent increase in money demand would result in a $2.4 trillion decrease in expenditures on the products of industry a. With money expenditures in that industry falling in 80 percent, a proportional decrease in the price level would be 80 precent. With industry a making up 20 percent of the economy, the price level falls 16 percent. This raises real balances approximately 2o percent.

While the scenario of a very low velocity is possible, the notion that a reasonable decrease in the prices of a few products facing lower demand because of an increase in the demand for money will avoid monetary disequilibrium is implausible. The more likely consequences is spreading disequilibrium--difficulty in making sales--solved only by a general deflation of prices.

Friday, November 19, 2010

Advocates of the productivity norm argue that the growth rate of money expenditures should equal the growth rate of factor supplies. Growing productivity should result in a deflationary trend. Negative "supply shocks" should result in less deflation, and if extreme enough, stable prices or even inflation. Favorable supply shocks should result in greater deflation than usual. Assuming that the trend growth rate in factor supplies is 2 percent and factor productivity grows one percent, then a money expenditure rule consistent with the productivity norm should have a 2 percent growth rate of money expenditures. The trend deflation rate would be 1 percent.

Unfortunately, the CBO estimate of productive capacity suggests that the economy has suffering slow productivity growth recently. Further, money expenditures have fallen approximately 13 percent below the trend growth path of the Great Moderation. The price level has only fallen 2 percent below its trend growth path. The result is real expenditure and real output about 6.4 percent below the depressed estimate of productive capacity.

The price level as measured by the GDP deflator is 111 in the third quarter of 2010. The CBO estimate of potential income is $14,167 billion in 2005 dollars. The level of money expenditures that would generate $14,167 billion in real expenditures is $15,740 billion.

Suppose a new 2 percent growth path starts now with the initial level being $15,740 billion. The target for the third quarter of 2011 would be $16,058 billion. Money expenditures would need to grow 10 percent to return to that growth path over next year.

Money expenditures are initially at a level so that real expenditures equal the CBO estimate of potential income. Assuming that the CBO estimates are correct, then this initial price level will gently rise and then fall.

In the diagram below, the blue line shows the GDP implicit price deflator. The red lines shows what its value would be to keep real expenditures equal to the productive capacity of the economy, given the target for money expenditures. Up until the third quarter of 2010, this is assumed to be the 5 percent growth path of the Great Moderation and so the red line is showing an implicit price level target. What price level is consistent with keeping real expenditures equal to the CBO estimate of productive capacity, if money expenditures continued on the growth path of the Great Moderation. For the third quarter of 2010 and forward, what is shown is the price level consistent with real expenditures equal to the CBO estimate of the productive capacity of the economy, assuming money expenditures are on the adjusted growth path. There is a large drop in the implied target price level, so that it is equal to the actual price level starting in third quarter of 2010.

The inflation rate is shown below. The black line shows the trend inflation rate from the Great Moderation. The blue line shows the actual inflation rate. The red line shows what the inflation rate would have been if money expenditures had remained on target and real expenditures remained equal to the CBO estimate of potential income. It is an implied target for the inflation rate. Up until the third quarter of 2010, this refelcts the 5 percent trend growth path of money expenditures from the Great Moderation. The large deflation shown is for the implied target, and since the price level is already well below that target, the result would by a shift from the actual inflation rate that happens to be almost exactly on the trend of the Great Moderation, to the new, much lower one.

The sceneario described here involves a subtantial rapid increase in the growth of money expenditures--approximately 1o percent over the next year. The level of money expenditures at that time would be consistent with real expenditures equal to the CBO estimate of potential income. The "target" for the price level actually increases from 111.1 to 111.5. This slight inflation occurs because the CBO estimate of the growth path of productive capacity is only 1.6 percent over the period. Since the rule is based on the assumption that that factor supplies (like labor and capital) will rise 2 percent, productivity growth is negative. However, CBO estimates that productive capacity will begin to grow 2 percent starting at the first quarter of 2012 and rise above that, and so the rule will start to generate mild deflation after that point.

I still lean towards shifting to growth path of money expenditures that shifts to a 3 percent growth rate sometime in 2008. Rather than a productivity norm, I favor a stable trend price level, and accept that that the slowing of the growth rate of productivite capacity should be reflected in an adjustment to a higher price level. However, if one takes a more hardline anti-inflationary approach, it still looks like a very significant increase in the growth of money expenditures are appropriate over the next year.

During the Great Moderation, money expenditures remained very close to a 5 percent growth path. During the Great Recession, money expenditures, as measured by Final Sales of Domestic product, have fallen approximately 13 percent below that trend growth path. The price level, as measured by the GDP implicit price deflator, is approximately 2 percent below its growth path. Real expenditures and real GDP are about 11 percent below their growth path.

If the productive capacity of the economy has continued on its growth path from the Great Moderation, then real output is far below that growth path. If the Fed had increased the quantity of money enough--undertaken sufficient quantitative easing--then real expenditures and real output should have remained near that growth path. The price level should have remained very close to its 2 percent growth path of the Great Moderation.

The CBO estimates that the productive capacity of the economy has grown slowly for the last several years. The estimated growth rate for the third quarter of 2010 was only 1.5 percent, about half of the long term trend. If money expenditures had continued to grow with the 5 percent growth path of the Great Moderation, the price level would have risen and so, the inflation rate would have been substantially higher.

Some of the critics of quantitative easing complain that it will be inflationary. There are many possible reasons for this view--most of which involve the assumption that the Fed will not be willing or able to sell off the assets it has accumulated and reduce base money when needed. Another possible concern, however, would be that the CBO has failed to properly estimate the decrease in the productive capacity of the economy. Perhaps all of the decrease in real output reflects a decrease in productivity.

The principle of market clearing suggests that if the productive capacity of the economy has fallen by anything less than 11 percent, there would be surpluses of goods and services and an incentive for firms to lower their prices. That would increase real expenditures and real output, bringing it back up to the productive capacity of the economy. The implication, then, is that because the price level is only 2 percent below its trend of the Great Moderation, the productive capacity of the economy has fallen approximately 11 percent below its trend.

If money expenditures had remained on the growth path of the Great Moderation, and the productive capacity of the economy had fallen approximately 11 percent below its growth path of the Great Moderation, then the result would have been a very significant increase in the the price level. The inflation rate would have been much higher.

In the following diagram, the trend growth rate of real GDP from the Great Moderation is shown in black. It has a 3 percent growth rate and is also the trend growth path of the CBO estimate of productive capacity during the Great Moderation. The green line shows the CBO estimate of potential income, and it began growing more slowly in 2006. It is now 3.8 percent below the trend of the Great Moderation. The blue line (which is difficult to see,) is real GDP. The red line is an estimate of potential income based upon "market clearing" principles. It is simply the same as real GDP during the Great Moderation and the Great Recession. On this view, the Great Recession was a very large downward shift in the growth path of potential income, and the trend then continues based upon the average rate since the recovery began, which is almost exactly 3 percent.

The focus on growth paths is a bit unconventional. It is much more common to just look at the growth rates. The growth rates are shown in the following diagram. The black line shows the 3 percent trend growth rate for the Great Moderation. The green line shows the growth rate of the CBO estimate of potential income. Notice that it is now approximately 1.5 percent, very low compared to the long term trend. The blue line is the growth rate of real GDP. The red line is the market clearing growth rate of potential income. It follows real GDP growth, but it estimated trend from during the recovery is almost exactly back on the long term trend growth rate of the Great Moderation.

What about the price level. Suppose money expenditures--Final Sales of Domestic Product--had remained on its growth path of the Great Moderation. (In my view, that would have required quantitative easing in 2008 and 2009.) The equilibrium price level would depend on potential income. The red line represents the price level consistent with the assumption that the entire decrease in real GDP was due to a decrease in potential income. The green line is the price level consistent with the CBO estimate of potential income. The black line is the price level consistent with potential income remaining on the trend growth path of the Great Moderation (both real GDP and the CBO measure of potential income had an approximately equal growth path.) The blue line is the GDP deflator.

The inflation rates consistent with these changes in the productive capacity are shown in the diagram below. The large spike in the red line shows the double digit inflation that would have occurred if money expenditures had remained on target, but potential income dropped as much as real GDP. Note that it returns to the trend inflation rate of the Great Moderation. The green line shows the modestly higher inflation rate that would be consistent with money expenditures continuing on target, but potential income remaining at the depressed level estimated by the CBO. The inflation rate would have risen above the trend of the Great Moderation to 3 percent and then, in recent quarters to nearly 4 percent. The black line shows the trend inflation rate of the Great Moderation. The blue line shows the actual inflation rate.

Since money expenditures fell far below the growth path of the Great Moderation, and are now approximately 13 percent "too low," a return of money expenditures to its trend growth path would result in a substantial change in the price level. The 21 percent increase in money expenditures needed to return to the growth path of the Great Moderation in a year would, at best, be expected to return the price level to the point consistent with real expenditures equal potential income. What would be the implied inflation rate? If potential income had remained at the growth path of the Great Moderation, the inflation rate over the next year would be expected to be 4.8 percent. If potential income has been growing at the anemic rate estimated by CBO, then the inflation rate would be 10.3 percent. And if the decrease in real GDP was entirely due to a decrease in potential income, and the recovery reflects a return to trend, then the inflation rate over the next year would be the remarkable 16.3 percent.

These rather high inflation rates (especially if potential income has been depressed) might suggest a more gradual approach to the long run trend of money expenditures. A two year adjustment would limit the inflation rate if potential income has remained on its long term trend would be 3.5 percent. If the CBO estimate is correct, then a two year adjustment would imply 7 percent inflation. And if all of the decrease in real GDP was due to a downward shift in the productive capacity of the economy, then a return to the trend growth path of the Great Moderation would require 9.5 percent inflation over two years.

I favor an adjusted growth path for money expenditures--a three percent growth path starting at some point in 2008. Such an adjustment not only allows a shift to a zero inflation rate in the long run, it also reduces the the transitional inflation generated by an increase in money expenditures.

Thursday, November 18, 2010

One of the issues regarding quantitative easing is that it is risky. By purchasing longer term bonds, the Federal Reserve is subject to interest rate risk. If interest rates rise, say, due to higher expected inflation, then the value of the Fed's asset portfolio will fall. If it falls below the value of its liabilities--the currency and reserves it has issued--then it will become insolvent.

Now, Murphy doesn't focus on the possible insolvency of the Fed directly, but rather notes that if the Fed needs to reduce the quantity of base money through open market sales, it is the market value of each asset that determines how much base money is destroyed by the sale. If the total market value of all the Fed's assets is less than needed decrease in the quantity of base money, then the Fed cannot use open market sales to reduce the quantity of base money enough.

For example, suppose the Fed undertakes quantitative easing and base money rises to $2.6 trillion. Money expenditures begin to rise, resulting in higher prices (and, hopefully, higher production.) The rising prices lead people to expect higher inflation. Long term interest rates rise. Some of the assets the Fed currently holds, which includes mortgage backed securities and longer term bonds, fall in current market value because of the increase in interest rates.. If the Fed wants to get base money all the way back to $800 billion, then it will need to sell approximately $1.8 trillion worth of assets. If the market value of its asset portfolio falls more than 31 percent, then the Fed will be out of assets to sell, and base money will still be greater than $800 billion.

As we imagine the Fed following this policy and reducing base money, the expected inflation should decrease, raising the market value of the bonds. While, normally, selling off these assets would tend to lower their prices because of the liquidity effect, remember, that the reason base money needs to drop is that banks are strongly expanding lending, perhaps by making commercial loans, but also by purchasing bonds.

Presumably, the sensible strategy for the Fed would be to sell off all of the bonds it holds with short terms to maturity, and hold off on selling the long term bonds. But it is possible that it would need to sell off long term bonds and mortgage backed securities at a loss. And if the losses are great enough, the Fed might become insolvent, and further, the insolvency could become so great that it would not have enough assets to reduce the quantity of base money enough to keep money expenditures from rising too much, resulting in above target inflation.

Murphy does make an odd error when discussing the possible strategy of the Fed paying higher interest on reserves. He says that investors will figure out that an exponential increase in reserves will hardly allow the Fed to control inflation. Now, suppose the expected inflation rate does rise to 10 percent and that a 12 percent interest rate is needed so that the demand for reserves will be high enough so that the demand for base money remains $2.6 trillion. Murphy seems to imagine that since each reserve balance would increase by 12 percent each year, base money would rise at a 12 percent annual rate. No. The Fed would simply have to sell between $200 billion and $300 billion in assets each year to leave base money the same. Rather than having to sell off $1.8 trillion in assets post haste, they could sell much fewer assets and prevent any excess inflation. Of course, controlling inflation would require the Fed sell more assets than the amount needed to keep the quantity of base money constant while paying sufficiently high interest rates to maintain the demand for reserves. While insolvency might still be the eventual result, there is time to get inflation and inflation expectations under control.

Speaking of the interest rates paid on reserves, these future risks are a reason why the interest rate on reserves should be cut from its current low level to zero, or perhaps negative. This at least partially substitutes for the need for quantitative easing and so for the amount of longer term securities the Fed needs to buy now. The fundamental problem that quantitative easing should solve is an excess demand for base money. Quantitative easing involves the Fed bearing increased risk for banks and their depositors. The banks get to hold low risk reserves, and the Fed holds the long term bonds with interest rate risk.

The possibility that the Fed might become insolvent, and even so insolvent that it cannot undertake the needed contraction in base money should not be a deterrent to quantitative easing. If necessary, the government should bail out the Federal Reserve. The simplest approach would be for the Treasury to swap the Fed's long term bonds for short term bonds at par. The Fed can then sell the short term bonds to contract the quantity of base money. The Treasury, of course, will have to sell new short term bonds to pay off the ones the Fed sold when they come due. The interest rates the treasury will have to pay will be higher, and so this will increase the government's interest expense. And the government should pay that expense and reduce other sorts of expenditures. Of course, the point of quantitative easing is to expand money expenditures on output, and raise production and employment. This will tend to reduce government social expenditures and raise tax revenue, helping with the deficit.

If the Fed becomes insolvent, there is little doubt that it would become subject to greater political scrutiny. Good. Fundamental monetary reform is needed. Most importantly, Congress should impose on the Fed a rule for a slow, steady growth path of money expenditures. Since such a growth path is inconsistent with persistent high inflation, a large run up in interest rates due to expectations of out of control inflation would be less likely. Further, the amount of quantitative easing needed to expand money expenditures an appropriate amount would likely to be less with a clear commitment to expanding money expenditures.

He explains that the experince of the Great Moderation had persuaded him that the Fed had learned its lesson and was doing a tolerable job. Fundamental monetary reform was on his back burner. The Great Recession has caused him to lose confidence in the Fed.

Exactly.

In my view, we have learned that manipulating the federal funds rate to keep the inflation rate rising 2 percent from its current level, wherever that happens to be, leads to very bad recessions. But, the Fed doesn't seem to want to learn that lesson.

Wednesday, November 17, 2010

I suppose I am a quasi-monetarist. My view of QE2 (quantitative easing 2.0) is better late than never.

Quasi-monetarists are very similar to "old" monetarists. The only real difference is that quasi-monetarists have given up on rules for the quantity of money, mostly because they don't believe that M2 velocity (or any other measure of velocity) is more or less unchanging.

Let's review some similarities. Suppose the economy starts in equilibrium and the growth rate of the monetary base is increased. The monetary authority begins "monetizing the debt" at a more rapid rate by increasing its rate of open market purchases--the rate at which it buys government bonds.

Monetarists and quasi-monetarists agree that this may temporarily reduce nominal interest rates on bonds. This would be the liquidity effect. Both also agree that it can cause an expansion in bank lending. However, both consider these effects unimportant. The key result would be a more rapid growth rate of the quantity of money--the amount of currency and various types of deposits available for households and firms (other than banks) to hold.

The more rapid growth rate in the quantity of money generates more rapid growth in expenditures on final goods and services. This more rapid growth in money expenditures may result in more rapid growth in production and employment for a time, but the eventual effect will be a higher rate of inflation. If this change is permanent and the inflation is expected, nominal interest rates will rise to reflect this higher inflation rate. Real interest rates, real output, employment, and the unemployment rate all return to at least approximately their initial levels. For output and employment this would be a return to their prior growth path, since they are generally rising.

I think it is fair to say that all quasi-monetarists would oppose having the Fed initiate this process. If the economy were in equilibrium, more rapid growth in base money would not be a good policy. Both quasi-monetarists and old monetarists agree that shifting to a new growth path of the quantity of money and money expenditure with higher growth rates will not result in permanently higher levels of real output and employment. If velocity is more or less constant, then a higher growth rate of the quantity of money and a higher growth rate of money expenditures are more or less equivalent. And so, quasi-monetarists and monetarists agree.

Quasi-monetarists, however, are puzzled when "old" monetarists criticize quantitative easing using this sort of argument. Quasi-monetarists think it is obvious that the economy is no where near equilibrium, and so arguments that any increase in the growth rate of base money can only have temporary effects on production and employment but result in a permanently higher inflation rate do not directly apply.

A second area of agreement between quasi-monetarists and "old" monetarists involves some relationships between money and banking. Suppose that the demand for bank credit falls. While banks could simply reduce interest rates and keep their lending the same, it is certainly possible that banks would both lower interest rates and lower the quantity of lending, while increasing the amount of reserves they hold. This increase in "excess reserves" would result in a lower money multiplier. Given the growth path of base money, the quantity of money would fall to a lower growth path. The quantity of money would grow more slowly or shrink, and then resume growing, but it would be lower at each future date.

The decrease in the growth path of the quantity of money would result in a lower growth path for money expenditures--spending on final goods and services. In the short run, this will result in reduced output and employment. The unemployment rate will rise. In the long run, however, the result will be that the price level shifts to a lower growth path, the real quantity of money returns to its previous growth path, and real expenditures, real output , and employment will rise back to their previous growth paths. The unemployment rate more or less falls back to its initial level.

In this scenario, there is never a shortage of credit or any particular reason to expect higher nominal interest rates. The decrease in the quantity of money, however, still results in reduced spending, which in the short run results in a recession--reduced output and higher unemployment.

"Old" monetarists favored a rule for the growth rate of the quantity of money. If there is a decrease in the money multiplier, for any reason, such a rule implies that the monetary authority--the Fed--should expand the quantity of base money however much is necessary to offset the decrease in the money multiplier and keep the quantity of money on the target growth path. Generally, this would involve increased "monetization of the debt." Open market operations--purchases of government bonds--would accelerate for a time, sufficient to offset any decrease in the money multiplier.

If the reason for the reduced money multiplier was an increase in the demand for currency by the public, or else banks deciding they need to hold more reserves without there being any decrease in the demand for bank loans, then the decrease in the money multiplier would occur along with shortages of credit and higher interest rates. However, in the special case where the demand for bank credit falls, and the lower interest rates motivate banks to hold more reserves, then the decrease in the money multiplier is associated with surpluses of bank credit and falling interest rates.

For both quasi-monetarists and "old" monetarists, what is happening to bank credit and interest rates is not important. A rule for the quantity of money requires that the monetary authority--the Fed--expand the quantity of base money the amount needed to offset the decrease in the money multiplier and get the quantity of money back up to its target growth path. This will prevent the decrease in the real output and employment. This will prevent the increase in the unemployment rate. It will make unnecessary the decrease in the price level that would otherwise be necessary to allow for the recovery of the real quantity of money and real expenditures.

It is certainly possible, and even likely, that the efforts of the monetary authority to offset the decrease in the money multiplier would result in lower interest rates than would otherwise occur--at least in the short run. It is possible that the expansion in base money would result in higher bank lending than would otherwise occur. However, the purpose of the increase in base money isn't to reduce interest rates or expand bank lending. The purpose to to offset the decrease in the money multiplier, prevent or reverse any decrease in the quantity of money, and prevent or reverse any decrease in money expenditures on final goods and services.

Both quasi-monetarists and "old" monetarists would agree that allowing a decrease in the quantity of money and money expenditures to a lower growth path is disruptive to the economy and should be avoided. If prices, including the prices of resources such as labor, were perfectly flexible, then the decrease in the growth path of the quantity of money and money expenditures on output would simply result in an immediate decrease in prices and wages. The real quantity of money and the real volume of expenditures would be unchanged. Real output and employment would be maintained. The unemployment rate would not rise.

However, prices and wages are not perfectly flexible, and so real output and employment will be depressed, perhaps greatly. That is why preventing a decrease in the quantity of money and money expenditures is important.

Both quasi-monetarists and monetarists share bewilderment when laymen (particularly central bankers) claim that there is no need to expand base money when the quantity of money is falling because interest rates are very low, banks have plenty of reserves, and there is plenty of money available for businesses to borrow.

Both quasi-monetarists and "old" monetarists try to explain that credit is being confused with money. If keeping the quantity of money on target requires unusually low interest rates, then interest rates should fall. If banks are holding large amounts of reserves by historic standards, then their unusually high demand to hold reserves should be accommodated. If the reason banks are choosing to hold more reserves is a low opportunity cost--lending opportunities look bad--that is irrelevant. It doesn't matter why the banks want to hold more reserves. It doesn't matter why the money multiplier has fallen. The quantity of base money needs to be increased to offset the decrease in the money multiplier.

What about foreign exchange rates? Like "old" monetarists, quasi-monetarists favor floating exchange rates. Changes in the relative competitiveness of domestic and foreign industries, changes in desired capital flows, should simply result in a change in the exchange rate. Ifvelocity is unchanging, then stable growth of the quantity of money implies stable growth of money expenditures. Suppose keeping the quantity of money on target required the monetary authority to make open market purchases to offset a decrease in the money multiplier. If market conditions result in falling interest rates, and this somehow results in a lower exchange rate, then so be it. The purpose of the increase in base money wasn't to lower interest rates or the exchange rate. The purpose was to keep the quantity of money and money expenditures growing on target. The impact on interest rates and exchange rates are consequences of the rule.

What about changes in productivity? Both quasi-monetarists and "old" monetarists recognized that the productive capacity of the economy can sometimes grow more rapidly and other times more slowly. It is even possible that the productive capacity of the economy might fall. The classic examples are a poor harvest or an "oil price" shock.

By simple arithmetic, the immediate effect of such a "supply" shock is a higher price level and lower real output. The price of the good with the adverse supply shock rises, and given all the other prices have yet to change, the price level rises. The shift of the price level from a lower to a higher level is inflation--a rising price level. If the economy already suffers from inflation, the inflation rate picks up for a time as the price level moves to a higher growth path.

At the same time, the decrease in the production of the good with the decrease in supply, given the output of all other goods, is a decrease in real output and real income. If real output is growing normally, the result could be a temporary slowing of production, with real output moving to a lower growth path and then normal growth resuming. However, if the supply shock is large enough, real output might fall absolutely before growth results.

If the growth rate of the quantity of money is maintained and velocity is constant, then money expenditures continue to grow at an unchanged rate. The arithmetic inverse relationship between inflation and output is constrained to be inversely proportional. If prices go up 1 percent, real output falls 1 percent. If prices rise 2 percent faster, output grows 2 percent more slowly.

While some advocates of a money supply rule may consider the inflation resulting from a decrease in productivity as undesirable implication of the rule, others consider it to be a virtue. A contraction of money growth and money expenditures to prevent any increase in the price level would create additional disruption of market coordination, exacerbating the problems created by an adverse change in productivity. Similarly, that unusual growth in productivity would have the opposite effect--that prices move to a lower growth path, implying temporary deflation, is better than some system of engineering an expansion in money growth and money expenditures to keep the price level from falling.

I think that most, if not all, quasi-monetarists take the position that changing money expenditures to prevent changes in productivity from impacting the price level is undesirable.

That the traditional money supply rule, assuming more or less unchanging velocity, would fail to keep the price level stable in the face of shifts in productivity counts as a virtue.

So what is the difference between quasi-monetarists and "old" monetarists? Quasi-monetarists don't believe that velocity is more or less unchanging and so do not favor a money supply rule. Instead, just as "old" monetarists favored having the monetary authority adjust base money enough to keep some measure of the money supply on a stable growth path, quasi-monetarists favor monetary institutions that cause the quantity of money to adjust whatever amount is needed to keep money expenditures on a stable growth path. In other words, the quantity of money should adjust to offset any change in velocity.

Assuming a monetary authority controls the quantity of base money, then that means that base money must change enough to offset both changes in the money multiplier and changes in velocity. An alternative way to describe the view is that the quantity of base money should be determined so that it matches what the demand for base money would be if money expenditures were on target.

Quasi-monetarists understand that adjusting base money to keep money expenditures on target is more difficult than adjusting base money to keep some measure of the quantity of money on target. There is some hope that a strong commitment to a target for money expenditures would help. But more importantly, quasi-monetarists believe that there is no good alternative. The "old" monetarist approach of stabilizing some measure of the quantity of money has become very undesirable in the face of large changes in velocity. The demand to hold money does not grow at a slow steady rate, and so, some scheme of adjusting the quantity of money to accommodate changes in the demand to hold money is necessary.

Still, the views of quasi-monetarists and "old" monetarists on the relationship between monetary institutions and bank lending, interest rates, exchange rates, and productivity shocks are similar. So, for example, the notion that interest rates are currently low and banks have plenty of excess reserves are not an argument against quantitative easing. If the exchange rate falls because of quantitative easing, so what? Did "malinvestment" in single family housing reduce the productivity capacity of the economy? Perhaps, but that is no reason for a decrease in money expenditures.

No, the key difference is that quasi-monetarists believe that if money expenditures remain below the target growth path, then base money was too low, while "old" monetarists would instead say that if their preferred measure of the quantity of money (perhaps M2) is too low, then base money was too low. And they will insist that velocity will bounce back up soon.

Tuesday, November 16, 2010

The article starts off by suggesting that interest rates rising despite the Fed's purchases defeats the purposes of the policy--lower long term interest rates. Of course, later in the article it does mention that "rosier economic data" as being a possible cause of the higher rates.

But I would like to focus on one of the last paragraphs of the article. "Corporate bond issuance has been heavy since the Fed announced its bond-buying plan, which often leads to a temporary selloff in Treasuries." Now, how does that work?

Corporations are selling newly issued bonds, which should raise the rates. People who currently own Treasuries sell them to obtain funds to purchase the new corporate bonds, which dampens any increase in the rates on the corporate bonds. The Fed buys some of the Treasury bonds being sold with newly issued money, and so dampens the increase in interest rates for the Treasuries and corporate bonds.

The only message I would take from this headline is that the Fed needs to quit focusing on interest rates. The purpose of quantitative easing isn't to lower interest rates compared to their current levels. Maybe BAA corporate rates still need to fall, but most interest rates should be higher. The purpose of quantitative easing is to raise money expenditures. And, hopefully, to raise real output and employment.

Sunday, November 14, 2010

Does keeping the nominal quantity of money stable in the face of an increase in the demand for money protect against distortions in relative prices? Does an increase in the quantity of money that accomodates an increase in the demand to hold money cause more disruption to the market economy than simply allowing lower prices for those goods whose demand falls?

A simple numerical example shows that the "deflationist" argument ignores the real balance effect and fails to account for the addititional burden placed on the market order needed to generate that real balance effect.

There are five equally sized industries, A through E ,making up a $15 trillion dollar economy. The quantity of money is $1.5 trillion. The demand for money rises 20%, or $300 billion. Those choosing to accumulate money reduce their expenditures on the products of industry A, so that the demand for the products of that industry (the flow of money expenditures) falls from $3 trillion to $2.7 trillion.

Under the first monetary institution, the nominal quantity of money rises by 20%, or $300 billion. The money is all spent on the products of industry E, causing the demand to rise from $3 trillion to $3.3 trillion. Total demands for industries B, C, and D are all unchanged, remaining $3 trillion each, adding up to $9 trillion. The demand for the products of industry A is $2.7 trillion, and the demand for the products of industry E is $3.3 trillion. Total money expenditures on output remains $15 trillion. A market signal is given for industry A to contract and for industry E to expand. The money and real demand for the products of industry A decreased by 10 percent. The money and real demand for the products of industry E have increased by 10 percent.

Under the second monetary institution, the nominal quanity of money remains $1.5 trillion. The price level falls by approximately 17%, so that the real quantity of money rises 20%. The lower price level implies that money expenditures and incomes in the economy need to fall to approximately $12.5 trillion in order for real expenditure to remain the same.

Again, money expenditures in industry A falls $300 billion as before to $2.7 trillion, but because of the lower price level, there is an additional 17 percent decrease to $2.25 trillion. Suppose industries B through E each have a 17 percent decrease in money expenditures, or 500 billion each, so that each are $2.5 trillion. Total money expenditures are then $12.25 trillion. But that is $250 billion less than the $12.5 trillion that reflects the 17 percent decrease in the equilibrium price level. Real expenditures appear to have decreased by $250 billion.

Fortunately, this ignores the real capital gain of those who initially held the $1.5 trillion. The 17 percent decrease in the price level creates a $250 billion real capital gain. It is that real capital gain from holding money that forms the real balance effect. Expenditure of that real capital gain is what causes real expenditure to return to equilibrium.

Suppose those receiving this capital gain increase expenditures on the products of industry D. The result is a decrease in money expenditures in every industry. Money expenditures fall $500 billion in industries B, C, and E. Money expenditures fall $750 billion in industry A. Money expenditures fall $250 billion in industry D. Real demand is unchanged in industry B, C, and E. Real demand in industry A has fallen 10 percent. The real demand in industry D has risen by 10 percent.

The problem with this monetary insitution is that each and every industry is given a market signal to contract. Industry A, B, C, D and E can only sell a smaller volume of goods at current market prices. For industry A, the signal is at least in the right direction. The real demand for its product has fallen and it should contract production. Of course, the 25 percent decrease in money expenditures on its product (from $300 billion to $225 billion) is excessive when the real demand has only dropped 10 percent. More troubling, the real demands for the products of industries B, C, and E are unchanged, yet all of them received the same type of market signal as industry A, less money expenditures and a smaller volume of sales at current prices. Any reduction in output is inappropriate. But most troubling, industry D, which has a 10 percent increase in real demand, also receives a signal that it should contract output. Money demand for its product falls by a bit more than 8 percent, and the amount that can be sold at current prices falls, when the industry should be expanding output.

In the typical market economy the result of all those industries facing lower demand will be reduced production and lower demand for resources, especially labor. The resulting surpluses of those resources results in lower prices for them, including wages. From the point of view of industies A, B, C, D, and E, these are lower costs. As costs fall, Industry D, facing the smallest decrease in demand returns to profitability first and so finally expands production in a way consistent with the increase in real demand. Industries B, C, and E, whose real demand is unchanged, return to profitability next, and output recovers consistent with the intital level. Industry A, with the reduced real demand, may recover to some degree, but its volume of output remains lower, reflecting its reduced real demand. In the end, resources shift from industry A to industry D. Of course, what should have happened is that industry B, C, and E should have had unchanged output, industry D should have expanded from the beginning, and only industry A should have contracted, but only 10 percent, not as much as 25 percent.

This thought experiment was a one time 20 percent increase in the demand to hold money. Once this is accomplished, it is possible, even likely, that the demand for the products of industry A will recover and the demand for industry E (for the first monetary institution) and industry D (for the second monetary institution) will fall back to their previous levels. Since short run elasticities of supply are typically low, the expansion of output in industry E might be limited. Further, if this temporary increase in demand is misperceived as being permanent, firms might make investments in specific capital goods that will be lost. However, this same situation would face industry D with the second monetary institution, which benefits from the real capital gains as the price level falls. Its initial return to profitability as costs fall more than demand may result in malinvestment if the temporary increase in real demand was wrongly perceived as permanent.

In conclusion, the notion that a lower price level necessarily allows for an adjustment of the real quantity of money to an increase in the demand to hold money without any increase in relative demands for particular goods is false. The notion comes from a failure to account for the real balance effect, which is necessary for real expenditures to recover. Further, it is clear that industries with no change in real demands suffer reductions in money expenditures, which are easily misperceived as reductions in real demand. Even industries with increasing real demand can suffer reduced money expenditures demand, resulting in the exact wrong signal.

Saturday, November 13, 2010

Why are many free market economists so critical of the Fed's proposed quantitative easing? I will suggest four reasons: the quantity theory of money, the public finance view of money creation, a focus on growth rates rather than levels, and an assumption of market clearing.

The first "problem" is the quantity theory of money. The quantity theory of money provides many valuable insights, but sometimes can be misleading. My bottom line version of the quantity theory of money is simple. Given the nominal quantity of money and the real demand to hold money, the price level adjusts so that the real quantity of money accommodates the real demand to hold money.

The Fed proposes to purchase $600 billion in government bonds. The monetary base is approximately $2 trillion, so the Fed is proposing a 30 percent increase in the nominal quantity of money in less than a year. Ceterisparibus, the price level must rise 30 percent so that the real quantity of money adjusts to this higher nominal quantity of money. And so, the quantity theory of money suggests that quantitative easing is highly inflationary.

The fundamental problem with this approach is that if a monetary authority is constrained by a rule controlling any nominal quantity other than base money itself--the inflation rate, the price level, nominal income, or even the price of gold, then the quantity of base money can't be treated as given. (The quantity of base money can't be taken as given with a rule controlling the nominal interest rate, but that sort of target is so counterproductive it is not worth considering.)

The Fed appears to be targeting a 2 percent inflation rate, so increasing base money by 30 percent and then waiting for some kind of long run impact on the price level (particularly a 30 percent increase) violates the rule. If the resulting inflation rate is anything more than 2 percent, then the Fed will be bound by its rule to reverse course and decrease base money so that no more than an additional 2 percent inflation occurs.

If the Fed had an explicit price level rule or a rule for money expenditures, the tentative nature of any increase in base money would be clearer. If an increase in base money, however large, causes the price level or money expenditures to rise above its target value, then it must be reversed. Whatever the long run effect of a given $2.6 trillion of base money might be for the price level, the actual quantity of base money will change the amount necessary to hit the Fed's nominal target.

The second problem is the public finance view of money creation. From this perspective, government can finance spending by collecting taxes, borrowing, or issuing new money and spending it. Especially when combined with the quantity theory of money, the implication seems to be that the desire of government to spend determines the quantity of money and the quantity of money then determines the price level. From this perspective, changes in the quantity of base money are one way--every increase is permanent, having funded new government spending. In particular, the 30 percent increase in the quantity of base money is funding part of the recent increases in government spending, and so, should eventually result in a 30 percent increase in the price level.

This approach applies to an unconstrained monetary authority-- the Zimbabwe of recent times, for example. But if a monetary authority is constrained by any nominal target other than the quantity of base money itself, then money creation is better understood as borrowing. The monetary authority can issue zero interest hand-to-hand currency, borrowing at a zero nominal rate. Reserve balances are much the same, with the monetary authority paying the interest rate it chooses on the balances banks keep with it.

The reason the issue of base money is best understood as borrowing is that the monetary authority must stand ready to reduce the quantity of base money if necessary to meet the target. While the government might create money to spend, it must stand ready to issue more conventional, interest bearing debt, to withdraw that money from circulation if needed to meet its target.

The Fed operates as an independent central bank. It borrows by issuing hand-to-hand currency and reserves which allows it to fund a portfolio of assets. Traditionally, it mostly held government bonds of a variety of maturities, but recently, it went through a period where it made a large amount of loans and currently holds a substantial portfolio of mortgage backed securities along with government bonds. Quantitative easing involves the Fed borrowing $600 billion, most probably from banks that will hold reserve balances paying .25 percent interest and then lending the money by purchasing $600 billion of government bonds. As already explained, if this causes inflation to rise beyond the Fed's 2 percent target, the Fed will need to sell off some of its assets, perhaps these bonds it has purchased, and "pay off" the currency or reserves it issued to fund them.

With a gold standard, the obligation to redeem the paper money issued by the monetary authority--currency and reserves-- with gold shows that it is a type of debt. If the demand for this type of debt should rise substantially, then a large increase in the quantity is possible. The monetary authority can borrow at a zero interest rate (or at whatever interest rate it chooses to pay banks on their reserve balances.) However, if the demand for currency and reserves should fall, then the monetary authority must pay it back. For the Fed, "paying it back" would involve selling off securities in its asset portfolio. Of course, if the Fed refused to contract the quantity of base money to match the decreased demand, redemptions of currency and reserves for gold would force it to do so.

While a rule for inflation, the price level, or money expenditures would not have such a simple enforcement mechanism, if the rule is somehow enforced, the Fed would similarly be obligated to reduce the quantity of base money--currency and reserves--to match any decrease in demand. With such a rule, that currency and reserves show up as liabilities on the Fed's balance sheet is no illusion. And, the government cannot simply print money and spend it. It can run a budget deficit and finance the national debt by borrowing through the issue of currency and reserves--but only to the limit that follows from the amount households and firms are willing to lend given the rule.

A third problem is excessive focus on growth rates rather than levels. Since increasing amounts of labor and capital along with improving technology results in a growing productive capacity for the economy, growth rates are important. During the Great Moderation, a growing quantity of base money generated a growing quantity of currency and bank deposits available for households and firms to hold, money expenditures growing at an annual rate of about 5 percent, prices rising about 2 percent per year, and real expenditures growing about 3 percent per year, which matched the approximate 3 percent growth rate of productive capacity. Employment grew about 2 percent a year, which matched the 2 percent growth rate of the labor force.

For the economy to remain in equilibrium, all of these growth rates need to balance. If the economy starts in equilibrium, then as long as the growth rates are appropriate, the economy will stay in equilibrium. If the economy starts in equilibrium, and the growth rate of base money shifts to 30 percent, the eventual result would be that money expenditures would grow approximately 30 percent per year, and the inflation rate would rise from 2 percent to 27 percent. Quantitative easing looks bad.

Further, an examination of recent growth rates suggest that the economy isn't far from equilibrium. The growth of money expenditures as measured by Final Sales of Domestic Product in the third quarter of 2010 was 2.8 percent. The growth rate of real output was approximately 2.4 percent, and the inflation rate was 2.25 percent. (Nominal GDP grew faster than Final Sales of Domestic Product because of a substantial build up of inventories.)

While the growth rate of real output of 2.4 percent is a bit low, it is higher than the CBO estimate of the growth rate of the productive capacity of the economy--1.5 percent. Personally, I consider a 2.8 percent growth rate for money expenditures to be near ideal. And not only is the inflation rate of 2.25 percent above the Fed's vague target of 2 percent, my view is that zero inflation is the proper goal. How do these figures come close to justifying a 30 percent growth rate for base money? Supply-side reforms aimed at getting productivity to rise looks to be the proper policy response.

But this is all an illusion created by excessive focus on growth rates. If the economy were at equilibrium, then that would be reasonable enough, but money expenditures are nearly 13 percent below the level of the Great Moderation. The price level is 2 percent below the level of the Great Moderation. Real GDP is about 6.4 percent below the CBO estimate of potential income and 10 percent below growth path of the Great Moderation.

The more than 100 percent increase in base money over the past two years--about $1 trillion-- has had only a modest impact on the measures of the quantity of money available for households and firms to hold. A one time, mostly likely temporary, increase in the monetary base of 30 percent is not out of line with the large apparent disequilibrium in growth paths. In particular, returning money expenditures to the growth path of the Great Moderation would require a 21 percent increase over the next year. It is very possible that the increase in the monetary base would be too little.

The final problem is the principle of market clearing. The concept of market clearing is an essential building block of economic analysis. The notion that any surplus--desired sales greater than desired purchases--will promptly result in a price sufficiently low so that the plans of the sellers and buyers match has important macroeconomic implications. For example, other things being equal, if money expenditures fall to a growth path 13 percent below the Great Moderation, the price level should simply fall in proportion--13 percent below its growth path. Otherwise there would be surpluses of various goods and services, implying that the price level is too high. Once the price level falls 13 percent, the flow of real expenditures rises back to its previous growth path, equal to the unchanged growth path of the productive capacity of the economy.

The price level, however, has only fallen 2 percent below its growth path of the Great Moderation and real expenditure is about 11 percent below its growth path. Assuming the growth path of the productive capacity is unchanged, there should be massive surpluses of goods and services. While firms would like to sell more, they cannot, and so reduce production to match the depressed real volume of sales. Needing less labor to produce this lower level of output, hiring should fall, perhaps layoffs expand. The surpluses of goods turn into surpluses of labor. When asked why they are not producing more and hiring more, firms might be expected to respond that their problem is weak sales. When asked why they are not working, the unemployed might complain that there are not enough job openings.

But this scenario is inconsistent with the principle of market clearing. If there were surpluses of goods and resources, then the price level would fall. If the price level has only fallen 2 percent, it must be because the existing level of real expenditures (approximately 11 percent below the growth path of the Great Moderation,) is equal to the current productive capacity of the economy. The principle of market clearing implies that the productive capacity of the economy must be 11 percent below that of the Great Moderation. While the CBO estimate suggests that the productive capacity of the economy has only fallen 4 percent below the growth path of the Great Moderation, their estimation procedure is inconsistent with the principle of market clearing and must somehow be in error.

If polling shows that firms claim they are not producing more because of weak sales, this must be an illusion. The principle of market clearing clearing implies that the problem must be bottlenecks of key resources. Workers may complain about an inability to find jobs, but the principle of market implies that problem must be that workers would prefer to collect extended unemployment benefits, or are choosing to retire early because of high taxes, or that the unemployment is limited to unskilled workers constrained by the minimum wage from working at lower pay.

If the productive capacity of the economy really has fallen about 11 percent, and the natural rate of unemployment has risen to about 9.4 percent, then the economy is in equilibrium, and the current growth rates in money expenditures, inflation, and real output are roughly in balance. I doubt it.

I think the most reasonable assessment of the economy is that prices and wages remain "too high" for the current growth path of money expenditures, and that rather than waiting for what appears to be a very slow process of market adjustment through lower prices and wages--perhaps complicated by expectations that a recovery of money expenditures is eminent--the better approach is to reverse the decrease in money expenditures and get them back to a reasonable growth path.

I favor a modified growth path for money expenditures--3 percent rather than 5 percent. The Fed should adjust the quantity of base money, increase it or decrease it, whatever amount is needed to stay on that growth path. In effect, the Fed can and should borrow by issuing currency and reserves in a variable amount. If the demand for base money rises, so that banks, other firms, and households want to lend a large amount to the Fed, then the Fed should borrow that amount. And if the demand for base money falls, then the Fed needs to pay it all back by selling off some of the assets it has accumulated. If the Fed stays on target, then the growth rates should all stay in balance, but if it fails, then the growth rates should adjust to return to the target growth path. Finally, if the productive capacity of the economy changes--grows more rapidly or more slowly, or even falls, then the growth path of the price level, and so the inflation rate, should be allowed to change.

From my perspective, the Fed allowed money expenditures to fall and money expenditures are far too low. Increasing base money through quantitative easing is a move in the right direction. Treating the increase in base money as given, or as funding government spending, or as a permanent increase in the growth rate are mistaken. Looking at current growth rates at very low levels is a mistake. As is treating market clearing as a principle, and failing to recognize an economy suffering from a depressed level of real expenditures.

Wednesday, November 10, 2010

During the Great Moderation, money expenditures remained very close to a 5 percent growth path. During the Great Recession, money expenditures dropped well below that growth path. As measured by Final Sales of Domestic Product, money expenditures are 13 percent below the growth path of the Great Moderation. Even if the growth rate of money expenditures returned to 5 percent, the growth path would remain 13 percent below that of the Great Moderation.

Why is this a problem? For real expenditures, and the real volume of sales, to return to the growth path of the Great Moderation, the price level must also fall 13 percent below its growth path from that period. Since it is now only about 2 percent below that growth path, there is 11 percent to go. While an immediate 11 percent deflation of prices (and wages) would rapidly solve the problem, and then allow for a resumption of 5 percent growth of money expenditures, 2 percent inflation, and growth of real expenditures of 3 percent, the most likely consequence of 5 percent growth in money expenditures starting from the current, depressed level, would be slow inflation or even mild deflation for an extended period of time. Only a very gradual return of real expenditures to its past growth path would be possible. Output and employment would remain depressed for an extended period.

An alternative approach would be more rapid growth of money expenditures--faster than the past trend growth rate--to return to the old growth path, after which 5 percent growth of money expenditures would resume. To return to the growth path of the Great Moderation one year from now, a 21 percent growth rate would be necessary. A two year adjustment path would require roughly 12.5 percent growth in money expenditures each year.

What about inflation? If the return of the money expenditures to its growth path of the Great Moderation simply returns the price level and real output to their previous growth paths, then the inflation rate would be about 4.6 percent. Of course, after a year of readjustment, the inflation rate would return to 2 percent.

However, the logic of that approach suggests that real expenditures (and real output) would increase at a 14.6 percent annual rate. That would be a happy result if possible. Unfortunately, even if the entire decrease in output was due to depressed sales, such a rapid recovery of production may be impossible. Even higher inflation might occur, resulting in the price level rising above its long term growth path. As production catches up, then inflation would again slow, this time moving down to the long term growth path.

There is reason to believe that the productive capacity of the economy has been reduced. Part of this is temporary--a need to shift labor and build capital goods appropriate to a new pattern of production, one that includes less residential investment. However, part of the shift will be permanent reflecting the loss of capital, including the skills of workers, specific to home construction.

The Congressional Budget Office estimates potential income--the productive capacity of the economy. Assuming their estimates are correct, potential output in the third quarter of 2010 is 3.8 percent below the trend growth path of real GDP for the Great Moderation. While real output is currently nearly 10 percent below the trend growth path of the Great Moderation, it is only 6.4 percent below the CBO estimate of potential output.

If money expenditures returned to its trend value of the Great Moderation in one year ($17,652 billion in the third quarter of 2011,) and real output returned to the CBO forecast of potential output, ($14,399 billion) the market clearing price level would be 122.6, which implies a 10.3 percent inflation rate and 8.6 percent growth in real output over the coming year. Again, assuming the CBO's estimates of potential income are correct, thereafter, the 5 percent growth path of money expenditures would be consistent with real output growing with capacity at approximately 2 percent a year and inflation running at 3 percent a year. If the return to the growth path of money expenditures is spread over 2 years, and the inflation rate over those two years would need to average 7 percent and real growth would be 5 percent per year.

(If the CBO estimate of potential income is correct, then there is no need for real expenditures to return to the growth path of the Great Moderation. Since potential income has fallen nearly 4 percent below that growth path, and with the price level already 2 percent below its growth path, the price level (including wages) need only drop 6 percent. )

I have long favored a noninflationary growth path for money expenditures and have proposed shifting to a new 3 percent growth path. My proposed growth path shifts to the lower growth rate at the third quarter of 2008, which is when money expenditures began to drop. With this alternative growth path, money expenditures are currently 8.4 too low, and would need to grow 12.4 percent over the next year to reach the targeted level--$16,415 billion.

If the price level remained at its current value of 111, the resulting increase in real expenditures would remain 2.6 percent below the growth path of the Great Moderation. For real expenditure and real output to return that growth path, the price level would need to fall to 108, which would require 2.6 percent deflation.

However, if the CBO estimate of potential income is correct, then the price level consistent with the real expenditures equal to potential output ($14,399.6 in third quarter of 2011,) would be 114. This would imply about 2.6 percent inflation over the coming year. After that point, the 3 percent growth in money expenditures would result in an inflation rate of about one percent--at least if the CBO estimate of continued slow growth in productive capacity is correct.

In my opinion, the Great Recession began in the third quarter of 2008. While I have no complaint with the NBER dating the recession as beginning in December of 2007, the first three quarters of recession where similar to the two recessions during the Great Moderation. Only in the third quarter was there a break, with a sharp decrease in money expenditures. In the third quarter of 2008 the Great Recession began.

However, suppose the shift in growth paths--the initial point of the new 3 percent growth path-- occurs at the official start of the recession, first quarter 2008. This slightly lower growth path would imply a target of money expenditures of $16,119 billion for the third quarter of 2011. It is currently (third quarter of 2010) 6.7 percent below the target and to reach the target in one year, it must grow 10.4 percent.

In the diagram below, the trend of Final Sales of Domestic Product during the Great Moderation (2004-2008) is shown in black. Adjusted trend one shifts to a 3 percent growth rate starting in the third quarter of 2008. Adjusted trend two shifts to a 3 percent growth rate in the first quarter of 2008.

If the price level remained at its current value, real expenditures (and real output) would be more that 4 percent below the trend growth path of the Great Moderation. The price level necessary for real expenditures to be back to that growth path is 106, which would require deflation of 4.4 percent. However, if the CBO estimates of potential income are correct, then the price level necessary to keep real expenditure equal to the productive capacity of the economy is slightly less than 112. The implied inflation rate would be one percent. This would imply that happy result of real expenditure and real output rising 8.6 percent, closing the output gap between the current value of real GDP and the CBO estimate of potential one year from now. After that point, real output would presumably grow at the anemic levels estimated by CBO, approximately 2 percent, and the inflation rate would remain at approximately 1 percent.

In the diagram below, the price level consistent with the CBO estimate of potential income and the 5 percent growth path of the Great Moderation is shown in black at labled P (trend.) During this period, the inflation rate is approximately 3 percent. That is because the CBO estimate of potential output grows at the rather anemic 2 percent. P (adj. 1) shows the price level consisent with a 3 percent growth path of money expenditures starting in the third quarter of 2008 and P (adj. 2) shows the price level consistent with the 3 percent growth path starting at the first quarter of 2008.